Bonds have not had a good start to 2021. The average UK Gilt fund is down 7% and every other bond sector – with the exception of high yield – is in negative territory too*. But why is this?
While the imminent sharp rebound in activity in the US has excited equity investors looking to profit from the economy re-opening, concerns about overheating and a consequent spike in inflation that would drive up interest rates have been mounting.
The 10-year US Treasury yield (US government bond) has surged from 0.93% at the start of the year to 1.7% today** – its highest level since the COVID-19 pandemic hit the West over a year ago. 10-year yields in Australia and New Zealand are also up by nearly 1% since the end of 2020.
Rathbones CIO Julian Chillingworth explained: “Government bond yields are rising because of steadily growing concerns about inflation: when inflation starts rising, returns need to keep pace, otherwise the value of investors’ capital is eaten away. And while the actual change may seem small, it means that the borrowing cost has roughly doubled in a short space of time.
When yields rise, prices fall
The issue for bond holders is that when bond yields go up, their prices fall, and investors lose money. Imagine you are choosing between a savings account that pays 0.25% interest and a government bond that offers interest of 1%. You may well pick the bond. But, over a year or so, imagine the central bank raises interest rates and high street banks follow suit. Now, a savings account might pay you 2%. Suddenly, the 1% rate that was fixed when the bond was issued doesn’t look so appealing and so its price is likely to fall.
Because the income paid by bonds is usually fixed at the time they are issued, high or rising inflation can also be a problem as it erodes the real return you receive. For example, although a bond paying interest of 3% might sound great on its own, if inflation is 2%, your ‘real return’ is only 1%.
What we’ve been seeing in the last few weeks is investors thinking inflation will rise – especially in the US as the economic recovery looks to be strong – and therefore central banks may increase interest rates faster and sooner than expected. This has pushed up the yields on government bonds and caused bond prices to fall.
Monster stimulus in the US
Rathbone Global Opportunities manager James Thomson told us: “Investors are now digesting the reality that the total US stimulus spend is going to be much bigger than the $1.9 trillion headline figure trailed by the Biden administration. According to Raymond James’ strategist, the average family of four in the US will receive stimulus cheques and child tax credits worth $14,000 in 2021. And shiny roads, bridges and airports will come later.”
Jonathan Golan, manager of Schroder Sterling Corporate Bond, added: “I have been worried about US inflation due to unprecedented stimulus coupled with prodigious excess savings. Trump’s cheques to the American people have barely cleared and now new and more generous cheques are in the mail.
“An economy with a 3% output gap and $6 trillion in excess savings is now getting 5-6% of GDP additional stimulus, courtesy of the new administration. This is an unprecedented cocktail. Typically when you exit a recession the consumer is overleveraged, but not this time. That’s why I positioned Schroder Sterling Corporate Bond defensively in terms of interest rate risk going into 2021.”
The Federal Reserve remains cautious
At its meeting this week, the Federal Reserve (US central bank) increased its US growth expectations for the year to 6.5% from the 4.2% forecast in December, which would mark the fastest economic expansion since 1984. However, over the next two years, real GDP growth is expected to drop to 3.3% and then 2.2%, respectively.
Officials took a dovish stance on this data, signalling that interest rates are likely to remain unchanged until 2024, despite a significant upgrade to US growth forecasts.
While this could provide some comfort to bond markets, Paul O’Connor, head of multi-asset at Janus Henderson Investors, warned that the monetary tide is nevertheless turning. “Whereas, back in December, only five of 18 Fed officials predicted higher rates in 2023, seven now expect a rate hike in that year and a third of the committee expects that more than one will be needed,” he said.
Mark Holman, CEO at TwentyFour, added: “In my view the Federal Reserve (US central bank) is too anchored in the present and is refusing to comment on the future. Markets are fully aware that over eight million jobs still need to be created to recover those lost to the US economy last year, and they are fully aware that the upcoming inflation is transitory. But markets are also fully aware just how fast everything has happened in this cycle so far.
“We would welcome some recognition from the Fed that should the economy recover quicker, stronger or in a more sustained fashion than it expects, then of course it would react if inflation risks were in excess of its tolerance.”
What should bond investors do?
Do falling prices mean more opportunity to buy bonds at lower valuations or should investors beware?
“The sell-off has been worse in those bonds with more duration (time until the bond matures),” commented Darius McDermott, managing director of FundCalibre. “The longer you have to wait for the payback, the more risk of the bond being affected by future interest rates.
“As such, long duration bonds like government bonds have fared worse, and shorter duration bonds like high yield – whose underlying companies will also do better in a cyclical recovery – have done better.
“In the short term, we believe we are more likely to see US Treasuries at 2% than 1%. But we are unsure whether these rates will be sustained over the long-term as the deflationary forces we had before the pandemic – aging populations, high debt, and low growth – remain.
“As a whole, we still don’t like many parts of the bond market. We do believe that bonds form a part of a balanced and diversified portfolio, but prospective returns look weak relative to equities.”
Best performing Elite Rated Bond funds so far in 2021*
|1||Man GLG High Yield Opportunities||5.05%|
|2||Aviva High Yield Bond||1.78%|
|3||M&G Optimal Income||0.99%|
|4||GAM Star Credit Opportunities||0.73%|
|5||Invesco Monthly Income Plus||0.65%|
|6||Man GLG Strategic Bond||0.64%|
|7||TwentyFour Dynamic Bond||0.56%|
|8||Baillie Gifford High Yield Bond||0.45%|
|9||Nomura Global Dynamic Bond||-0.05%|
|10||AXA Sterling Credit Short Duration||-0.08%|
*Source: FE fundinfo, total returns in sterling, 1 January 2021 to 18 March 2021
**Source: US Department of Treasury, 18 March 2021
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